How Stock Market Bubbles Are Formed
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In 1987, Per Bak, a Danish physicist, came up with the idea of "self-organized criticality," which became one of the most important discoveries in statistical physics.
His theory explains how complex systems, like the stock market, behave. The main idea is that small events can, over time, cause massive changes within these systems.
To paint a picture of this concept, imagine you start dropping single grains of sand onto a large, flat table. At first, the sand spreads out evenly across the surface. But as more grains are added, they start to pile up.
As the pile gets steeper, it becomes more unstable. Eventually, it reaches a point where just one more grain of sand causes an avalanche, and the whole pile comes crashing down.
The stock market, as a complex system, works in a similar way.
Rising share prices are like grains of sand being added to the pile. With each new grain added, the instability of the market increases, and the makeup of the market starts to change.
At first, Rational Agents—those who make decisions based on a company’s fundamentals—start selling their stocks as prices get too far away from intrinsic values. This leaves room for Noise Traders, who are more driven by market momentum (and FOMO) than fundamentals.
This shift causes share prices to be propelled more by hype than by how well a company is actually doing, which leads to a bubble. This doesn’t just happen at the market level, either. It can occur at the individual stock level as well.
Each new Noise Trader entering the market pushes prices even higher (steepening the pile), but it’s impossible to know which event (bad earnings, breaking news, etc.) will be the straw that breaks the camel’s back, triggering the eventual, large-scale come down (the avalanche).
When the party is finally over, and when share prices come back down, the makeup of the market will shift back to a higher concentration of Rational Agents, and the cycle will start all over again.
In a nutshell, that’s how stock market bubbles are formed. Now I want to hear from you: Which stocks do you think are in a bubble right now? Write to me here and let me know.
And click here to learn about 4 stocks that would be great buys if the stock market avalanches.
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SINCE YOU ASKED 💬
"Do you only invest in dividend stocks in your portfolio?"
- Bobby | YouTube
Yes! Every single one of my holdings pays a dividend, and there are a few reasons why I only invest in dividend-paying stocks:
One of the main reasons is that dividend payments are not impacted by the random whims of the stock market. In other words, no matter what the share price is doing – whether it’s going up or it’s going down – you’re still going to receive your dividend payment.
Now as we all know, share prices can fluctuate pretty dramatically, often due to factors that have little to do with the company’s actual financial performance. News can break, and the share price either skyrockets or plunges based on that alone.
On the other hand, dividends are always tied to a company’s actual operations and its ability to generate profits and free cash flow.
If a company isn’t growing, profitable, or generating cash flow, there's no way it can’t sustain or grow its dividend. So, in a way, investing in dividend-paying stocks forces you to focus on fundamentally strong companies—which are the only types of companies you should want to invest in anyway.
On top of that, dividend investing is a very straightforward and low-stress way to invest. You just buy the stocks, hold onto them, collect the income, and reinvest it until you're ready to retire—it's literally as simple as that.
And since it's naturally a buy-and-hold strategy, you don’t have to worry as much about timing the market. Plus—and this is key—you don’t need to sell your shares to benefit from the investment. That's one of my favorite things about dividend investing.
Have a question? Ask me here to see it featured in an upcoming newsletter.
HOT TAKES 🔥
In last week's newsletter, I asked readers about the most recent additions to their portfolios. Here are some of the responses:
Matt said: I don’t have any new positions yet, but they will come early next week when I start them in JPM. My after-tax contributions from my 401k are finally starting to be rolled over to my IRA to help start the position. I’ll also use a portion of the contributions to complete my goal of 100 shares of SCHD, aka 300 post-split shares.
Chad said: I'm loading up on SCHD after the split. I think this ETF will see a return to $70 to $80 a share in a few years. The growth potential is wicked high at this point in time.
John said: ABBV, FCX, SNSXX
LAST WORD 👋
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Click here to join the DRIP N' Sip Discord group. Like I said, it's totally free, and I look forward to seeing you in there!
